How etfs measure up to other investments

Under a barrage of regulatory and media scrutiny, the benefits offered by ETFs seem to have been forgotten. Clare Dickinson tries to separate facts from fiction and look at how ETFs compare to other investments

ETFs have come under fire from various corners of the market this year. First various regulators examined them, then the losses at UBS – around which there is much speculation about the extent to which ETFs were used by the trader allegedly responsible – re-ignited the debates.

This has been used as fair game by parts of the financial market and the press to accuse ETFs of many things, most of which are less than positive. In response, the industry has argued that in terms transparency, ETFs are way ahead of the rest of the funds industry. When it comes to regulation and mitigation of risk, the industry says they are miles beyond other investments.

But how do they compare to other investments? ETFs are not the only investment which exposes investors to counterparty risk, they are not the only financial products to use derivatives, nor are they the only product which investors may not fully understand.

In relation to counterparty risk, ETFs have been subjected to much criticism. Counterparty risk in ETFs comes from two sources: in a swap-based ETF it comes from the swap, whereby the investor has exposure to the swap counterparty. In physically-backed ETFs counterparty risk arises when securities are lent out, in which case the counterparty that the investor is exposed to is the borrower of the stocks.

The vast majority of ETFs in Europe fall within the Ucits rules – the EU regulations for the fund industry – which are now in their fourth incarnation. Under Ucits, counterparty risk is limited to 10%; this is usually mitigated through the use of collateral.



Counterparty risk
What seems to have been ignored by much of the recent coverage of ETFs is that any investment will have some form of counterparty risk. The Greek debt crisis serves as a reminder of this; developed country government bonds have long been considered one of the safest investments, with the assumption that a government will always be able to service its debt. The situation in Greece, with the government unable to pay all its debts, serves as a reminder that no investment is infallible.

“If you trade with anyone you are immediately introducing counterparty risk and it is a cascade,” says Hywel George partner at Integral Asset Management.

“If you hold sovereign bonds you have to very careful these days about the counterparty risk; then you get into physical ETFs where your residual counterparty risk is in the stock lending and then you get into synthetic ETFs where you have exposure to a single counterparty.”